goldman sachs group, inc. gs - fisher college of … jurgens page 3 of 24 company overview1 goldman...

Goldman Sachs Group, Inc. GS

Current Price: $78.99 Price Target (1 yr): $102.93 Risk: HIGH Rating: BUY

Analyst Information

Analyst: Dave Jurgens Fisher College of Business The Ohio State University Contact: [email protected] Fund: OSU SIM (Bus Fin 824) Manager: Chris Henneforth, CFA Date: December 2, 2008

Stock Information

Sector: Financial Industry: Investment Banking &

Brokerage Market Cap: 25.94 B Avg. Volume (3mo): 29.00 MM 52 Week High: $229.35 52 Week Low: $47.41 YTD Return: ‐71.02% Dividend Yield: $1.40 (1.80%)

Year 2008E 2009E

EPS Estimates 8.12 10.12

Consensus 9.32 10.38

High 12.91 15.07

Low 6.79 9.32

Summary

Although Goldman Sachs is a cyclical stock in what has turned out to be a significant economic downturn, its stock price is depressed more than it should be to compensate for the decrease in investment banking activity. GDP is continuing to fall and credit is still tight, but the market has overreacted to these factors and has overly discounted Goldman’s earnings potential.

While GS’s transition to a bank holding company

may reduce profitability and future ROE it will not be as drastic as the market is currently projecting. Even if it is assumed that earnings power will be cut in half from the restructuring, multiples analysis shows that Goldman is still significantly undervalued. Moreover, while the transition might cause returns to be deflated relative to the past, the move to a bank holding company will also limit downside risk. This risk has been further alleviated through the investment from Berkshire Hathaway, the equity that was raised through a common share offering, and the government TARP.

Now that Goldman is one of the two remaining

domestic investment banks, it is in a dominant position to emerge from the current recession with huge increases in volume and profitability if it is able to weather the current economic storm.

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Table of Contents

Company Overview 3

Business Segments 3

Competitive Advantage 4

Economic Analysis 5

Growth Domestic Product 5

Availability of Credit 6

Interest Rates 6

Industry Analysis 7

Company Position 10

Catalysts/Concerns 11

Growth Opportunities 11

Risks 11

Financial Analysis 12

Multiples Valuation 15

Conclusion & Summary 16

References 18

Appendices 19

Appendix A: Pro Forma Income Statement 19

Appendix B: Pro Forma Discounted Cash Flow Model 20

Appendix C: GAAP Income Statement 21

Appendix D: GAAP Balance Sheet 22

Appendix E: GAAP Statement of Cash Flows 23

Appendix F: Third Quarter Earnings Release, Income Statement 24

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Company Overview1 Goldman Sachs (GS) is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base that includes corporations, financial institutions, governments and high‐net‐worth individuals. Goldman Sachs is the successor to a commercial paper business founded in 1869 by Marcus Goldman. On May 7, 1999, it converted from a partnership to a corporation and completed an initial public offering of its common stock. Their activities are divided into three segments: (i) Investment Banking, (ii) Trading and Principal Investments and (iii) Asset Management and Securities Services.

Investment Banking Investment Banking represented 16% of 2007 net revenues. Goldman Sachs provides a broad range of investment banking services to a diverse group of corporations, financial institutions, investment funds, governments and individuals and seeks to develop and maintain long‐term relationships with these clients as their lead investment bank. Their current structure, which is organized by regional, industry and product groups, seeks to combine client‐focused investment bankers with execution and industry expertise. They continually assess and adapt their organization to meet the demands of their clients in each geographic region. Through their commitment to teamwork, they believe that they provide services in an integrated fashion for the benefit of their clients. Their goal is to make available to its clients the entire resources of the firm in a seamless fashion, with investment banking serving as “front of the house.” To accomplish this objective, GS focuses on coordination among its equity and debt underwriting activities and its corporate risk and liability management activities. This coordination is intended to assist their investment banking clients in managing their asset and liability exposures and their capital. Trading and Principal Investments Trading and Principal Investments represented 68% of 2007 net revenues. Trading and Principal Investments facilitates client transactions with a diverse group of corporations, financial institutions, investment funds, governments and individuals and takes proprietary positions through market making in, trading of and investing in fixed income and equity products, currencies, commodities and derivatives on these products. In addition, they engage in market‐making and specialist activities on equities and options exchanges, and they clear client transactions on major stock, options and futures exchanges worldwide. In connection with their merchant banking and other investing activities, they make principal investments directly and through funds that we raise and manage. To meet the needs of their clients, Trading and Principal Investments is diversified across a wide range of products. GS believes its willingness and ability to take risk to facilitate client transactions distinguishes it from many of its competitors and substantially enhances client relationships.

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Asset Management and Securities Services Asset Management and Securities Services represented 16% of 2007 net revenues. Goldman Sachs’ asset management business provides investment advisory and financial planning services and offers investment products (primarily through separately managed accounts and commingled vehicles) across all major asset classes to a diverse group of institutions and individuals worldwide and primarily generates revenues in the form of management and incentive fees. Securities Services provides prime brokerage services, financing services and securities lending services to institutional clients, including hedge funds, mutual funds, pension funds and foundations, and to high‐net‐worth individuals worldwide, and generates revenues primarily in the form of interest rate spreads or fees. Exhibit A1 – Summary of GS Operating Segment Activities

Competitive Advantage Goldman Sachs’ competitive advantage has historically been its reputation as the best‐in‐class investment banking and brokerage firm. In the past it has been able to trade at a premium valuation relative to its peers because of its global reach, all‐star talent, peer‐best return on equity, significant operating leverage, and client relationships2. It has been a global leader in mergers and acquisitions advice and securities underwriting. GS also owns Goldman Sachs Execution & Clearing, one of the largest market makers on the NYSE. This has allowed GS to be a leading market maker for fixed income

Business Segment/ Component Primary Products and Activities Investment Banking:

Financial Advisory • Mergers and acquisitions advisory services• Financial restructuring advisory services

Underwriting • Equity and debt underwriting

Trading and Principal Investments: Fixed Income, Currency and Commodities • Commodities and commodity derivatives, including power generation and related

activities• Credit products, including trading and investing in credit derivatives, investment-grade corporate securities, high-yield securities, bank and secured loans, municipal securities, emerging market and distressed debt, public and private equity securities • Currencies and currency derivatives• Interest rate products, including interest rate derivatives, global government securities and money market instruments, including matched book positions• Mortgage-related securities and loan products and other asset-backed instruments

Equities • Equity securities and derivatives• Securities, futures and options clearing services• Market-making and specialist activities in equity securities and options• Insurance activities

Principal Investments • Principal investments in connection with merchant banking activities• Investment in the ordinary shares of Industrial and Commercial Bank of China Limited• Investment in the convertible preferred stock of Sumitomo Mitsui Financial Group,

Asset Management and Securities Services:

Asset Management • Investment advisory services, financial planning and investment products (primarily through separately managed accounts and commingled vehicles) across all major asset classes, including money markets, fixed income, equities and alternative investments (including hedge funds, private equity, real estate, currencies, commodities and asset allocation strategies), for institutional and individual investors (including high-net-worth clients, as well as retail clients through third-party channels)• Management of merchant banking funds

Securities Services • Prime brokerage• Financing services• Securities lending

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products, currencies and commodities6. Goldman’s premium valuation may narrow over the coming months as it shifts to a bank holding company and its earnings potential becomes less certain. However, for the time being Goldman remains one of two remaining traditional investment banks, and with the recent equity infusion from Berkshire Hathaway it appears as though Goldman will remain standing despite the poor economic conditions. Goldman’s size also provides it with a significant advantage over smaller investment banks. Large customer transactions typically require firms with substantial financial resources. Goldman has the financial and intellectual capital to close deals of this magnitude. Economic Analysis Growth Domestic Product Goldman Sachs and the financial sector in general are heavily dependent on the performance of the overall market. When the economy is healthy, the sector, particularly the investment banking industry, performs well and when the economy is bad the industry performs poorly. For example, during the last recession, the revenues of the four largest investment banks saw profit declines of close to 40 percent along with revenue declines of 25 percent3. When the economy is in bad shape investment banking services are not in high demand because companies tend to lack the excess capital needed to fund new projects and expand operations. The reverse is true when the economy is booming. Mergers and acquisitions tend to occur, private companies are taken public, institutions are able to take more risks, innovation and expansion occur, and investment banks are paid advisory fees to help provide funding and execute these tasks. Accordingly, investment banking performance is heavily tied to GDP. Over the past four quarters GDP has progressively worsened and is likely to continue to drop into the upcoming quarter. But, when the recent downturn begins to pick up, Goldman will have a huge upside potential. Exhibit B shows the strong positive correlation of Goldman Sachs EPS, financial sector EPS and GDP.

Exhibit B – Goldman Sachs EPS vs. Financial Sector EPS vs. GDP

StockVal®GOLDMAN SACHS GROUP INC (GS) Price 78.991999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

EARNINGS-PER-SHARE YTY % CHANGE (SMOOTHED)-51

-34

-17

0

17

34

51

68

85

102

HI 100.0 •LO -36.0 ME 23.1 CU -31.6

11-30-199908-31-2008

StockVal®S&P FINANCIALS SECTOR COMPOSITE ADJ (SP-40) Price 19.761999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

EARNINGS-PER-SHARE YTY % CHANGE (SMOOTHED)-45

-36

-27

-18

-9

0

9

18

27

HI 25.3 LO -81.2 ME 9.4 CU -81.2

12-31-199809-30-2008

GROSS DOMESTIC PRODUCT ($BIL) YTY % CHANGE (SMOOTHED)2

3

4

5

6

7

8

HI 7.2 LO 2.7 ME 5.4 CU 3.4

12-31-199809-30-2008

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Availability of Credit In order for the financial sector to function properly, institutions must have confidence that the money they are lending will be repaid. If proper credit cannot be established, banks lose confidence and liquidity dries up. When this occurs loans become more expensive and time consuming, and overall economic growth is restricted. This reduces volume and activity for investment banks leading to decreased profitability. One of the mostly widely used measures of domestic credit risk is the TED spread which is now calculated as the difference between the three‐month dollar LIBOR and three‐month Treasury Bills. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans is increasing. Conversely, a decrease in the spread means that the risk of default has subsided. The graph below shows that since the spread peaked in mid October at 4.65% (see Exhibit C), the rate has recently declined to 2.10%. A significant portion of this decline is likely due to the capital injections of the government bailout plan. While the spread has declined from the October highs, it is still well above its historical average of 0.22%. It is unlikely that credit conditions will worsen over the coming quarters, and while the spread is above its historic average by about 190 basis points it will continue to drop as markets begin to stabilize.

Exhibit C – TED Spread YTD

*Graph obtained from Wikipedia, data confirmed on Bloomberg Interest Rates Banks have historically had a strong negative correlation to interest rates. This relationship mostly relates to the previous point in that as interest rates drop liquidity tends to improve because banks become more willing to lend. Exhibit D shows that historically as interest rates drop (as measured by the Federal Funds rate) earnings in the financial sector rise and vice versa. However, starting in the fourth quarter of 2007 there has been a significant reversal of this trend. The recent financial crisis has been an anomaly in that the Fed’s attempts to bolster lending and the well‐being of banks in general through decreasing interest rates has had little effect. It is likely that the Fed will lower rates from its current 1.0% target rate by at least 50 basis points to on its December 16th meeting in an attempt to stimulate the economy. Interest rate futures show a year‐end funds rate between 0.25 percent and 0.5 percent4. While the aim of the cut would be to encourage banks to lend more to improve liquidity, it is

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difficult to tell if the cut will have the desired effect. Recently the cuts have not done the trick and credit markets have remained relatively frozen. Moreover, if the rates are eventually pushed to 0% the Fed will lose a key weapon in its arsenal to bolster lending. But, if the economy picks up sooner than expected and liquidity begins to flow, banks will be well positioned to reap significant profits.

Exhibit D – Interest Rates compared to Fin’l Sector EPS relative to S&P 500

Industry Analysis Goldman Sachs is in the Investment Banking & Brokerage industry. This industry is in the mature phase of its lifecycle. It is highly competitive and is heavily concentrated. With the recent fall of Lehman Brothers and mergers of Bear Sterns with J.P. Morgan Chase and Merrill Lynch with Bank of America, Goldman Sachs and Morgan Stanley are the only remaining standalone investment banks. Consolidation has been a recent trend as investment banks have merged with other types of financial institutions (commercial banks for example) in an attempt to remain competitive through broadened access to capital. Fees in the investment banking industry are typically standard prices, thus to remain competitive investment banks must rely on their reputation of intelligence and business effectiveness3. The Investment Banking & Brokerage industry is very cyclical. The YTD (through 10/31) performance of the S&P Investment Banking and Brokerage index is down 63.8% compared to a 33.8% decrease in the S&P 1500. This exemplifies how heavily the industry reacts to overall economic conditions. Conversely, when the market is booming the industry tends to outperform the market. Exhibit E on page 8 presents a comparison of Goldman Sachs versus the S&P 500 over the past ten years relative to GDP. The graph shows that during the 2001‐2002 recession GS performed worse than the S&P 500 whereas during the bull market of 2003‐2007 GS significantly outperformed the market.

StockVal®S&P FINANCIALS SECTOR COMPOSITE ADJ (SP-40) Price 19.761999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

EARNINGS RELATIVE TO S&P 500 COMPOSITE ADJUSTED (SP5A) M-Wtd YTY % CHANGE (SMOOTHED)-42

-35

-28

-21

-14

-7

0

7

14

21

HI 17.2 LO -78.5 ME 1.1 CU -78.5

12-31-199809-30-2008

FEDERAL FUNDS RATE (%) YTY % CHANGE (SMOOTHED)-88

-66

-44

-22

0

22

44

66

88

110

HI 100.0 +LO -80.3 ME -9.3 CU -80.3

11-27-199811-28-2008

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Exhibit E – Goldman Sachs relative to S&P 500 compared to GDP

Given the current poor economic environment, the Investment Banking & Brokerage industry would be expected to perform poorly. Demand for the industries’ services are driven heavily by economic activity that results in company mergers, acquisitions, public offerings, equity underwriting and financing needs. The majority of these sorts of activities have declined because of the looming recession and financial crisis. The number of merger and acquisition deals has steadily been decreasing from 4,278 in the fourth quarter of 2007 to 2,480 in the third quarter of 20085. Additionally, as can be seen in Exhibit F on page 9, equity related underwriting has declined by over 50% in September and October compared to the same period in 2007 and global IPO volume has almost completely ceased to exist. As can be seen in Exhibit G on page 9, fixed income issuance has also been dramatically reduced. Investment grade corporate debt issuance is down close to 60% in September and October relative to last year and high yield corporate debt issuance is almost nonexistent. In the simplest of terms, investment banks make money through acting as the intermediaries and assembling capital between those who are looking to invest excess capital and those who have a shortage of capital. Currently there is a lack of demand for this service to be performed. Nevertheless, because Goldman Sachs is one of two investment banks left and because the demand is currently at its lows, when business does begin to pick up it will be able to drive heavy volume.

StockVal®GOLDMAN SACHS GROUP INC (GS) Price 78.991998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

EARNINGS RELATIVE TO S&P 500 COMPOSITE ADJUSTED (SP5A) M-Wtd YTY % CHANGE (SMOOTHED)-39

-26

-13

0

13

26

39

52

65

78

HI 82.4 •LO -37.8 ME 10.0 CU -21.5

12-31-199909-30-2008

GROSS DOMESTIC PRODUCT ($BIL) YTY % CHANGE (SMOOTHED)2

3

4

5

6

7

8

HI 7.2 LO 2.7 ME 5.4 CU 3.4

12-31-199809-30-2008

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Exhibit F – Global Equity and Related Underwriting / Global IPO Monthly Volume

*Obtained from William Blair & Company 11‐14‐08 GS/MS equity research report

Exhibit G – Global Investment Grade Corporate Debt / High Yield Corporate Debt

*Obtained from William Blair & Company 11‐14‐08 GS/MS equity research report

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Company Position Over the past decade Goldman Sachs has set the “gold” standard in investment banking. It has had unparalleled prestige and has been able to constantly attract top talent. Goldman had been given the reputation of perhaps the savviest business dealer on Wall Street. It has focused most of its efforts on institutional clients, unlike its rivals who focused more on high net worth individuals6. This has helped them to gain a breadth of understanding for satisfying all sorts of business financing needs. However, Goldman’s status as the industry leader has been put to test in the current economic crisis as the investment banking & brokerage industry has been changed dramatically over the past several months. Goldman Sachs and Morgan Stanley are the only traditional investment banks who remain standing amid the turmoil. The other major rivals including Lehman Brothers, Bear Sterns and Merrill Lynch have either merged with larger banks or filed for bankruptcy due to their debt and credit problems. With the September 2008 Federal Reserve mandate that Goldman Sachs and Morgan Stanley become a bank holding company the independent brokerage firm model will cease to exist. The new structure will allow them to create commercial banks and hold customer deposits. This will bring several benefits to Goldman Sachs but may also lead to several restrictions which are likely to prevent it from achieving historic profitability. On the plus side, the transition will bolster Goldman’s resources so that they can stay in business and have less fear about liquidity issues. This will be done in a combination of three ways. First, Goldman can now acquire commercial banks which had historically been off limits for a traditional investment banking house. Second, it will be able to establish a deposit base through accepting funds from customers. Lastly, and perhaps most importantly, Goldman will now have access to the Fed discount borrowing window. Goldman has identified between $130 – 150 billion of current assets what it believes can be funded through bank deposits7. This would provide a cheaper funding base for the firm’s other activities and could continue to grow depending on the opportunities that arise. Overall, the change should strengthen the company’s balance sheet. On the down side, the restructuring could place limitations on Goldman’s ability to function as it previously had. With the access to Fed funding comes more strict and direct regulation. Specifically, the regulation could put restrictions on Goldman’s ability to continue with its proprietary trading and investment activities8. This could put a major damper on earnings as this practice has been the main contributor of profitability over the past several years (discussed more below). Additionally, Goldman’s past years of excess profitability have been fueled by the use of leverage and risk‐taking with the firm’s own capital. As a bank holding company, Goldman will become subject to the Fed’s thorough capital adequacy guidelines which include both risk‐adjusted and leverage capital adequacy ratio standards. At the end of 2007 Goldman’s leverage was nearing close to 25x8. These aggressive practices will likely be subsided as the firm shifts to a bank holding company. Leverage will likely fall more in line with the diversified financial industry where multiples of 10 – 12x are common. In the week following the announcement of Goldman’s transition to a bank holding company, Warren Buffet’s Berkshire Hathaway declared it would be investing $5 billion in the firm. Under the terms of the deal Berkshire Hathaway will receive shares of the banks perpetual preferred stock with a 10% dividend, as well as warrants for the purchase of an additional $5 billion in common stock at a strike price of $115 per share. The warrants may be exercised at any time through a 5‐year time horizon. Goldman also made another $5 billion worth of common stock available to the public in a seasonal offering. In addition, Goldman will be receiving $10 billion from the government as part of the proposed bailout plan. This funding should help to quell fears about any Goldman solvency issues or liquidity concerns.

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To help cut costs the firm announced on October 23rd that it would be cutting ten percent of its workforce. The drop has been consistent with other major banks including J.P. Morgan Investment Bank and Morgan Stanley both of whom cut ten percent of their workforce and Citigroup who cut close to 52,000 jobs.

Catalysts/Concerns Outlined below are several areas where Goldman Sachs has the opportunity to expand and drive growth as well as several areas that could be potentially threatening. Growth Opportunities One opportunity Goldman has to expand is to acquire a commercial bank. Now that it has switched to a bank holding company, Goldman could use the opportunity to merge with another type of financial institution in order to broaden access to capital. This could also help to diversify its business. Moreover, the increased deposit base would help to fund current operations at a lower cost. Given that Goldman’s Trading and Principal Investments line of business is expected to take a major header this year, and also given the fact that investment banking in general is more cyclical than most other industries in the financial sector, diversification could help to stabilize earnings. If the economy continues to worsen some attractive opportunities may present themselves, and GS will now be able to take advantage. Another opportunity for Goldman is to expand into new foreign markets. While competition is stiff in the United States and in most of Europe, there are opportunities in underserved countries. Certain less developed countries, such as Nigeria, have a large number of high‐wealth individuals who could potentially use the service of a world class investment bank3. However, with this expansion comes the risk of political instability and corruption. In terms of future earnings, even though Goldman has restructured to a bank holding company, the firm still has the same top talent that has enabled it to outperform its peers in recent years. It is for the most part expected for earnings to drop as the company de‐levers, however it may find a way to surprise and outperform consensus earning power. Especially if economic conditions begin to pick up, Goldman will be well positioned for substantial growth. Catalysts that could all lead to a dramatic turnaround for Goldman Sachs and the investment banking & brokerage industry include an increase in the transparency and efficiency of capital markets, an increase in investor confidence, and strong domestic and global business earnings. While these topics do not seem likely right now, if any combination of them do begin to occur, Goldman will be a major beneficiary, especially since only two domestic investment banks are still alive. Risks One area of concern for Goldman Sachs is its dependence on market volatility and GDP. A significant portion of Goldman’s business is driven by factors that cannot be controlled by the firm itself. While it can do the best it can to prepare itself against the risk of a market downturn, it is very difficult for an investment bank to thrive in a financial crisis. If the market continues to worsen losses could continue to mount for Goldman Sachs and shareholder equity could be severely hurt if the firm’s financial securities are not properly hedged.

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Another area of concern for Goldman Sachs is the possibility that the firm’s transformation to a bank holding company could have unintended consequences. The increased scrutiny from the Fed could limit the propriety trading and principal investment activities, which have been an integral part of the company’s profitability over the years. Additionally, the continued reduction in operating leverage could reduce future profitability and return on equity. All else equal, reduced leverage reduces returns to shareholders8. There is also a risk that a crisis of confidence could arise for Goldman Sachs as a firm. Goldman relies heavily on its reputation for literally every aspect of its business. Goldman’s reputation allows it to build relationships around the world and facilitate trading and advisory work for all sorts of institutional clients. Reputation is also important for finding new investments, having credibility to borrow capital from various sources, and subsequently using that capital. If investors and the market in general begin to lose confidence in Goldman Sachs its entire business model will be damaged. Another severe financial shock is possible and could feasibly turn sentiment against the company. Other areas of concern include the fact that Goldman remains relatively highly levered and still has risky assets on its balance sheet8. And while insolvency fears subsided after the firm’s move to a holding company and the capital infusion from Warren Buffet and the government, future write downs and a continued economic downturn could renew these fears. Financial Analysis Exhibit H outlines Goldman Sachs’ operating results by segment for the fiscal year ended November 2007. Investment Banking accounted for 14.2% of net sales while Trading and Principal Investments and Asset Management and Security Services accounted for 67.9% and 15.6% respectively. Investment Banking accounted for 14.2% of total profit while Trading and Principal Investments and Asset Management and Security Services accounted for 75.0% and 10.2% respectively. Note that complete versions of Goldman Sachs’ Income Statement, Balance Sheet and Statement of Cash Flows can be found in the appendices C, D and E respectively.

Exhibit H – Goldman Sachs 2005 – 2007 Operating Results by Segment

*Taken from GS SEC Form 10‐K Filing In terms of overall sales and total profit, the Trading and Principal Investments is the most important line of business. When looked at based on FY 2007 numbers, all three lines of business have been relatively strong over the past three years with significant growth in both revenues and profits in two of three segments. Of the three, Asset Management and Securities Services has had the weakest growth

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with a decrease in earnings of 24% year over year. This has largely been due to a 33% increase in operating expenses due to increased compensation and benefits expenses which were a result of a growth in employment levels and higher distribution fees. However, net revenues in the AM&SS group have increased 11% year over year. Within this LOB, asset management net revenues have increased 5% and securities services net revenues have increased 25%. And, from 2005 to 2006 net revenues in the AM&SS group increased 36% and pre‐tax earnings increased 45%1. Thus, this LOB remains relatively healthy. Each line of business had different products/trends driving revenue and profit growth in 2007. Investment Banking saw a 64% increase in Financial Advisory net revenues which was largely a result of industry‐wide completed mergers and acquisitions. The increase in the Trading and Principal Investments group can be heavily attributed to net revenues in Equities products which increased 33% year over year. During 2007, Equities operated in an environment characterized by strong customer‐driven activity, generally higher equity prices and higher levels of volatility. The Asset Management and Securities Services group saw an increase in customer balances due to global growth and higher management fees1. It is unrealistic to assume that Goldman’s future will follow the three year historic trends, but its past performance does reinforce its ability to generate strong results under the proper circumstances. Appendix F shows how drastically the current environment has affected Goldman’s performance. Most notably, Trading and Principal Investments Revenue is down 45% YTD and 67% relative to Q3 of 2007. This has been the main driver of Goldman’s most recent 47% decrease in earnings for the YTD. Appendix A details a forecasted pro forma income statement for fiscal years 2008 through 2010. The 2008 estimates were heavily based on Goldman’s third quarter earnings release that was released on September 16. Some slight changes were made to account for the fourth quarter which may be grim. FY 2008 and 2009 net revenues are projected to be $27.99 billion and $31.28 billion respectively. This is in line with average 2008 consensus estimates of $27.97 billion and slightly below 2009 consensus estimates of $32.57 billion. Earnings per share are projected to be $8.12 in 2008 and $10.12 in 2009, relative to consensus estimates of $9.32 and $10.38. The assumptions used in generating the pro forma income statement are detailed below:

• Revenue9 – The revenue breakdown by percentage of total sales is expected to remain constant and was based upon the average of the past five years.

o Investment Banking – Net revenues in investment banking are down 40% in Q3 of 2008 relative to 2007. This is largely due to an industry‐wide decrease in mergers and acquisitions and a substantial decrease in initial public offerings. A weak fourth quarter is expected, with a decline in revenue of 40%. Revenues are anticipated to begin to rebound in FY 2009.

o Trading and Principal Investments – Net revenues are down 67% in Q3 and 52% in Q2 of 2008 relative to 2007. This is largely due to weak results in credit and mortgage products both of which had significant declines in asset values. Net revenues in the equity group are also down 50% relative to Q3 of 2007 because of the decline of global equity prices, lower client activity, and weak results in the firm’s principal strategy investments. Yearly revenues are expected to decline by 65% and slowly begin to rebound in FY 2009.

o Asset Management and Securities Services – This is Goldman’s only line of business with positive YTD revenue growth. Revenues are up 6% YTD, but are down 5%

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relative to Q2 of 2008. Fourth quarter results are expected to yield a further decline in revenues as assets under management continue to fall because of depressed equity values. On a total yearly basis AM&SS revenues are expected to increase by 4% and continue to slowly grow through FY 2009 and 2010.

o Interest Income – Revenue is down 14% YTD. A total yearly decline of 15% is expected with a steady increase to interest income returning in FY 2009.

• Interest Expense – Interest expense as a percentage of revenues is expected to increase to 52.5% based on Q3 2008 numbers and is expected to be slightly reduced in the coming years.

• Compensation and Benefits – Compensation and benefits expense is expected to remain in line with past expenses. While it might have been increased this quarter as a percentage of revenues, this amount is offset by the workforce cut of 10% announced in October.

• Non‐operating Expense – Based on guidance from the GS Q3 earnings release non‐operating expenses are expected to rise to 52.5% of sales and begin to slowly decline in the coming years.

• Provision for Taxes – Taxes are assumed to be consistent with historical rates. • Preferred Stock Dividends – Preferred stock dividends are expected to increase by 35% a

year for the next three years based on the Berkshire Hathaway preferred investment of $5 billion and the government infusion of $10 billion.

• Basic Common Shares Outstanding – Common shares outstanding are expected to increase by 38 million shares from Goldman’s $5 billion seasonal stock offering.

• Diluted Shares Outstanding – Diluted shares outstanding are expected to increase by 38 million shares from Berkshire Hathaway’s preferred investment of $5 billion.

Based on the income figures produced in the pro forma income statement, a pro forma discounted cash flow model was generated and is detailed in Appendix B. The assumptions used in generating the pro forma DCF are detailed below:

• Revenue – The gross revenue projections for 2008 – 2010 flow directly from the pro forma income statements. Revenue is expected to slightly increase in 2011 and then steadily decrease to a terminal rate of 3.5%.

• Net Income – The net income projections for 2008 – 2010 flow directly from the pro forma income statements. Income growth is expected to drop off in 2011 as Goldman becomes more de‐levered and continues to taper off to a terminal rate of 3.5%. Note that net income equals free cash flows as changes in working capital are not relevant in forecasting free cash flows for financial companies.

• Shares Outstanding – Shares outstanding is taken directly from the pro forma income statement and is based on total dilutive shares outstanding.

• Terminal Discount Rate – The discount rate is determined by using the capital asset pricing model and is based on the following assumptions:

o Expected Rate of Return = R = rf + ß (rm ‐ rf) o rf = risk‐free rate is based on 10‐year T‐bill currently being quoted at 3.0% o rm = expected market return of 10.0% o ß = GS equity beta of 1.96 taken from Yahoo! Finance o R = 3.0 + 1.96*(10.0 – 3.0) = 16.72

• Terminal FCF Growth Rate – Expected to be 3.5% which is consistent with long term GDP growth.

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Based on the pro forma projections, Goldman Sachs has an implied equity valuation of $105.03 (see Appendix B). This represents a 32.9% upside to its 11/30/08 closing price of $78.99. A sensitivity analysis has also been included in Appendix B to show how variations in discount rate and terminal growth rate effect the implied stock valuation. The extremes range from $94.91 to $118.34. Multiples Valuation Analyzing Goldman’s multiples relative to the financial sector produces mixed results (see Exhibit I.) The multiples are based on ten year historic data. Assuming mean reversion, Goldman is expensive on a P/E and ROE basis and cheap on a P/B, P/CF, and P/E/G basis. Because of the recent turmoil that has completely shaken up the financial sector, and because the ratios do not produce any one‐sided results, no definite conclusions can be drawn from looking at Goldman Sachs relative to the sector. However, on an aggregate basis Goldman appears to be priced in line with financial sector.

Exhibit I – Goldman Sachs Relative to Financial Sector (SP‐40)

Analyzing Goldman’s multiples on an absolute basis produces more conclusive results. This analysis is outlined in Exhibit K. For the most part, Goldman is trading between its ten year low and ten year mean. Mean reversion is unlikely due to the fact that Goldman will be de‐levering from its historic average of between 20 – 25X to between 10 – 12X which is more typical of diversified financial banks. Because this leverage is expected to eventually be cut in half, target multiples were calculated to be the average of the ten year low and ten year mean. Note that the target EPS was taken from the pro forma income statement (see Appendix A.) Even with this relatively substantial (but reasonable) drop in target multiples, Goldman is undervalued based on three of five multiples and is significantly undervalued based on P/B and P/CF ratios. The average target price based on the multiples below yields a stock price of $100.84. This represents an upside of 27.7% relative to the 11/30/2008 closing price of $78.99. Exhibit K – Goldman Sachs on Absolute Basis

Both the DCF and multiples analysis yield an upside of well over twenty percent for Goldman Sachs. Assuming the DCF analysis and multiples analysis are equally as valuable and accurate at predicting

Stock vs. Sector Valuation

High Low Mean Current

P/Forward E 1.38 0.26 0.8 0.91P/B 1.87 0.82 1.11 1.07P/CF 0.93 0.25 0.76 0.29P/E/G ratio 1.52 0.45 0.89 0.56ROE 6.23 0.78 1.42 6.23

Absolute Valuation

High Low Mean Current Target Multiple

Target X/Share

Target Price

% Upside / Downside

P/Forward E 26.90 5.90 11.20 10.00 8.12 7.90 64.14 -18.8%P/B 5.60 0.60 2.40 0.80 1.50 98.74 148.11 87.5%P/CF 18.50 2.90 10.90 4.20 6.90 18.81 129.77 64.3%P/E/G ratio 1.60 0.40 1.00 0.60 0.70 131.65 92.16 16.7%ROE 56.00 11.20 21.60 18.50 16.40 4.27 70.02 -11.4%

$78.99 Average: $ 100.84 27.7%11/30/08 Stock Price:

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Goldman Sachs’ stock price, a target value can be established by taking the average of the two values ($105.03 and $100.84.) This yields a final, 12‐month target price of $102.93. Conclusion & Summary In conclusion, Goldman Sachs is rated a BUY with a target price of $102.93. This represents a 30.3% premium to the 11/30 closing price of $78.99. The table below summarizes key pros and cons for the investment recommendation.

Pros Cons • Goldman remains one of two standalone

investment banks in the United States, putting it in a solid position for growth and expansion once the market rebounds

• The switch to a bank holding company should help to provide liquidity, mitigate the risk of solvency, and provide access to a potentially cheaper funding base

• When the market turns around, Goldman will be in great shape to generate significant profits – the financial crisis could also be more short‐lived than expected

• Goldman still has the same intellectual capital and talent that has made it a global leader in the past

• If the market downturn continues to worsen longer than expected and credit spreads continue to widen, Goldman’s share price could continue to fall further as its business is heavily dependent on macroeconomic conditions that GS cannot control

• The switch to a bank holding company could have unintended consequences and could lead to significant restrictions on proprietary trading and principal investments, which have historically generated the lion’s share of revenues and profits

• Goldman remains highly leveraged and still holds risky securities on its balance sheet8

• If market sentiment turns against Goldman Sachs, its reputation could be severely damaged limiting future business opportunities and reducing profitability

Although Goldman Sachs is a cyclical stock in what has turned out to be a significant economic downturn, its stock price has dropped more than it should have to compensate for the decrease in investment banking activity. GDP is continuing to fall and credit is still tight, but the market has overreacted to these factors and has overly discounted Goldman’s earnings potential. With Goldman’s recent move to a bank holding company it is fair to assume that it will have to de‐lever from historic standards of 20 – 25X to closer to 10 – 12X. While this may affect profitability and future return on equity it will not be as drastic as the market is currently projecting. Even if it is assumed that earnings power will be cut in half from the restructuring, multiples analysis shows that Goldman is still significantly undervalued. Moreover, while the transition might cause returns to be deflated relative to the past, the move to a bank holding company will also limit the downside risk. This risk has been further alleviated from the investment from Berkshire Hathaway, the equity that was raised through a common share offering, and the government TARP. Now that Goldman is one of the two remaining domestic investment banks, it is in a dominant position to emerge from the current recession with huge increases in volume and profitability. Its shares are trading near all time lows, as the entire banking industry has come under pressure. However, the basic

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need for investment banking services will not change in the long run and after Goldman weathers the storm its shares will have considerable upside potential. GS still has the majority of the same capable management and employees that have enabled it outperform in the past. It is important to note that while it is strongly believed that Goldman has significant upside to its current trading price, there is a relatively substantial amount of risk in projecting Goldman’s future earnings. Because of this risk, Goldman has been given a risk rating of HIGH. This determination was made by considering several factors including the difficultly in accurately predicting future sales, the firm’s degree of financial leverage and its exposure to contingent events including fluctuations in GDP and credit availability. Moreover, Goldman’s most important line of business from an earnings standpoint is its Trading and Principal Investments group which has seen extreme fluctuations in asset values over the course of the year due to its exposure to equities, rates, commodities, mortgages, foreign exchange and credit, and exposure to leveraged loans, residential mortgages and broad principal investments. Having such a deep exposure to these items makes this line of business very challenging to forecast. Future regulation may also prove to completely alter the financial sector if the economy continues to deteriorate. This may lead to consequences that cannot be accurately predicted.

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References 1 Goldman Sachs Group, Inc. 2007 Annual Report

2 Standard & Poors, “Goldman Sachs Group, Inc.” November 15, 2008 Investment Report

3 Hoover’s, Inc. Investment Banking Industry Profile

4 Reuters.com, “FED FOCUS – Calls grow for zero rates, new Fed measures.”

5 Zephyr, “Quarterly M&A Report – North America, Q3 2008.” www.zephyrdealdata.com

6 Hoover’s, Inc. ‐ Goldman Sachs, Inc. Overview

7 William Blair & Company, L.L.C., “The Goldman Sachs Group, Inc./Morgan Stanley.” November 14, 2008

Investment Report

8 Morningstar Investment Research Center ‐ Goldman Sachs, Inc. Analyst Research

9 Goldman Sachs Group, Inc. 2008 Q3 Earnings Release

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Appendix A – Pro Forma Income Statement

David Jurgens - 11/30/2008 Goldman Sachs - GSIncome Statement Projection

FY FY FY FY FY FY FY FY(millions) 2010E 2009E 2008E 2007 2006 2005 2004 2003Investment banking 5,585 4,986 4,533 7,555 5,613 3,599 3,286 2,400Trading and principal investments 13,156 11,440 10,400 29,714 24,027 15,452 11,984 8,555Asset management and securities services 5,633 5,215 4,920 4,731 4,527 3,090 2,655 1,917Interest income 45,575 42,199 39,073 45,968 35,186 21,250 11,914 10,751 Total revenues 69,948 63,840 58,926 87,968 69,353 43,391 29,839 23,623Interest expense 34,974 32,559 30,936 41,981 31,688 18,153 8,888 7,600 Revenues, net of interest expense 34,974 31,282 27,990 45,987 37,665 25,238 20,951 16,023 Consensus Net Rev Estimate 32.57 27.97

Operating expenses:Compensation and benefits 16,088 14,683 13,553 20,190 16,457 11,758 9,652 7,515

Brokerage, clearing, exchange and disribution fees 2,758 1,985 1,416 952 829Market development 601 492 378 374 264Communications and technology 665 544 490 461 478Depreciation and amortization 624 521 501 499 562Amortization of identifiable intangible assets 195 173 124 125 319Occupancy 975 850 728 646 722Professional fees 714 545 475 338 253Cost of power generation 335 406 386 401 11Other expenses 1,326 1,132 709 827 625

Total non-compensation expenses 9,443 8,618 7,896 8,193 6,648 5,207 4623 4063

Total operating expenses 25,531 23,302 21,449 28,383 23,105 16,965 14,275 11,578

Pre-tax earnings 9,443 7,980 6,541 17,604 14,560 8,273 6,676 4,445Provision for taxes 3,220 2,721 2,230 6,005 5,023 2,647 2,123 1,440

Net earnings 6,223 5,259 4,310 11,599 9,537 5,626 4,553 3,005Preferred stock dividends 472 350 259 192 139 17 0 0 % change 35.0% 35.0% 35.0% 38.1% 717.6%

Net earnings applicable to common shareholders 5,751 4,909 4,051 11,407 9,398 5,609 4,553 3,005

Earnings per common share Basic 12.50 10.56 8.60 26.34 20.93 11.73 9.30 6.15 Diluted 12.24 10.12 8.12 24.73 19.69 11.21 8.92 5.87 Consensus EPS 10.38 9.32

Average common shares outstanding Basic 460 465 471 433.0 449.0 478.1 489.5 488.4 % change -1.08% -1.27% 8.78% -3.56% -6.09% -2.33% 0.23% Diluted 470 485 499 461.2 477.4 500.2 510.5 511.9 % change -3.09% -2.81% 8.20% -3.39% -4.56% -2.02% -0.27%

Total Sales Growth 10.9% 8.8% -34.0% 26.8% 59.8% 45.4% 26.3% Investment banking 12.0% 10.0% -40.0% 34.6% 56.0% 9.5% 36.9% Percent of Total Sales 9.2% 9.2% 9.2% 8.6% 8.1% 8.3% 11.0% 10.2% Trading and principal investments 15.0% 10.0% -65.0% 23.7% 55.5% 28.9% 40.1% Percent of Total Sales 36.1% 36.1% 36.1% 33.8% 34.6% 35.6% 40.2% 36.2% Asset management and securities services 8.0% 6.0% 4.0% 4.5% 46.5% 16.4% 38.5% Percent of Total Sales 7.2% 7.2% 7.2% 5.4% 6.5% 7.1% 8.9% 8.1% Interest income 8.0% 8.0% -15.0% 30.6% 65.6% 78.4% 10.8% Percent of Total Sales 47.5% 47.5% 47.5% 52.3% 50.7% 49.0% 39.9% 45.5%Gross Margin 52.0% 48.5% 47.0% 52.3% 54.3% 58.2% 70.2% 67.8% Chg YoY 3.5% 1.5% -5.3% -2.0% -3.9% -12.0% 2.4%Compensation to Sales 23.0% 23.0% 23.0% 23.0% 23.7% 27.1% 32.3% 31.8% Chg YoY 0.0% 0.0% 0.0% -0.8% -3.4% -5.2% 0.5%Non-compensation Opearting to Sales 13.5% 13.5% 13.4% 9.3% 9.6% 12.0% 15.5% 17.2% Chg YoY 0.0% 0.1% 4.1% -0.3% -2.4% -3.5% -1.7%Profit Margin 10.0% 8.5% 7.5% 13.2% 13.8% 13.0% 15.3% 12.7% Chg YoY 1.5% 1.0% -5.7% -0.6% 0.8% -2.3% 2.5% Interest Expense 50.0% 51.0% 52.5% 47.7% 45.7% 41.8% 29.8% 32.2% Interest Income (above)Tax Rate 34.1% 34.1% 34.1% 34.1% 34.5% 32.0% 31.8% 32.4%

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Appendix B – Pro Forma Discounted Cash Flow Model

David Jurgens - 11/30/2008 Goldman Sachs - GS Terminal Discount Rate = 16.7% beta per Yahoo Finance = 1.96Cash Flow Projection Terminal FCF Growth = 3.5%

(millions)Year 2003 2004 2005 2006 2007 2008E 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E

Revenue 23,623 29,839 43,391 69,353 87,968 58,926 63,840 69,948 76,943 83,867 90,577 96,917 102,732 107,869 112,183 116,110 % Growth 26.3% 45.4% 59.8% 26.8% -33.0% 8.3% 9.6% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.5%

Net Income 3,005 4,553 5,626 9,537 11,599 4,310 5,259 6,223 6,845 7,461 8,058 8,622 9,140 9,597 9,980 10,330 % Growth 51.5% 23.6% 69.5% 21.6% -62.8% 22.0% 18.3% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.5%

Free Cash Flow 3,005 4,553 5,626 9,537 11,599 4,310 5,259 6,223 6,845 7,461 8,058 8,622 9,140 9,597 9,980 10,330 YOY growth 52% 24% 70% 22% -63% 22% 18% 10% 9% 8% 7% 6% 5% 4% 3.5%

Terminal 80,994Terminal Value 80,994 P/E 7.8NPV of free cash flows 35,123 EV/EBITDANPV of terminal value 17,288 Free Cash Yield 12.8%Projected Equity Value 52,411Free Cash Flow Yield

Shares Outstanding 499

Current Price 78.99$ 2.5% 3.0% 3.5% 4.0% 4.5%15.7% $110.80 $112.46 $114.26 $116.21 $118.34

Implied equity value/share 105.03$ 16.2% $106.38 $107.86 $109.46 $111.19 $113.0716.7% $102.28 $103.61 $105.03 $106.57 $108.23

Upside/(Downside) to DCF 33.0% 17.2% $98.47 $99.66 $100.93 $102.30 $103.7817.7% $94.91 $95.98 $97.13 $98.35 $99.67

Sensitivity Analysis:Implied share price based on Discount Rate and FCF Growth:

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Appendix C – GAAP Income Statement

*Taken from GS SEC Form 10‐K Filing

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Appendix D – GAAP Balance Sheet


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Appendix E – GAAP Statement of Cash Flows


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Appendix F – Third Quarter Earnings Release, Income Statement

*Taken from GS Q3 Earnings Release

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